Extreme Networks, Inc. (EXTR) Q3 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Extreme Networks Third Fiscal Quarter 2013 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, John Kurtzweil, Chief Financial Officer. Sir, you may begin.

Thank you, Sam. Welcome to the Extreme Networks Fiscal 2013 Third Quarter Conference Call. On the call with me today from Extreme Networks is Chuck Berger, President and CEO. David Ginsburg, SVP Product Line Management and Chief Operating Officer, is on the call with us as well. This conference call is being broadcast live over the Internet and is being recorded on behalf of the company. The recording will be posted on the Extreme Networks' website for a replay shortly after the conclusion of the call and will remain there for 7 days. The presentations and recording of this call are copyrighted property of the company, and no other recording or reproduction is permitted unless authorized by the company in writing. This afternoon, Extreme Networks issued a press release announcing the company's financial results for the third quarter of fiscal 2013. A copy of the release and supporting financial materials are available in the Investor Relations section of the company's website at www.extremenetworks.com. This conference call contains forward-looking statements and involve risks and uncertainties, including statements regarding the company's expectations regarding the financial performance, the impact of its restructuring efforts, strategies, growth of customer demand, development of new products, customer acceptance of the company's products, customer buying patterns and spending patterns, and overall trends and economic conditions in the company's markets. Actual results could differ materially from these projected in the forward-looking statements as a result of certain risk factors, including, but not limited to, a challenging macroeconomic environment worldwide; fluctuations in demand for the company's products and services; a highly competitive business environment for network switching equipment; the company's effectiveness in controlling expenses, including the company's cost restructuring efforts; the possibility that the company might experience delays in the development of new technologies and products; customer response to its new technologies and products; the timing of any recovery in the global economy; risks related to the pending or future litigation; and the dependency on third parties for certain components and for the manufacturing of the company's products. The company undertakes no obligation to update the information on the call. More information about potential factors that could affect our business and financial results is included in the company's filings with the Securities and Exchange Commission. Throughout the conference call, the company will reference some financial metrics that are derived in accordance with Generally Accepted Accounting Principles, or GAAP. While these metrics are not in accordance with GAAP, this approach is consistent with how management measures the company's results internally. However, non-GAAP results are not in accordance with GAAP and may not be comparable to non-GAAP information provided by other companies. Non-GAAP information should be considered a supplement to, and not a substitute for financial statements prepared in accordance with GAAP. A reconciliation of the non-GAAP information to the corresponding GAAP measures is in the slide presentation under the Investor Relations tab on our website and accompanying our press release. Non-GAAP results exclude stock-based compensation, restructuring charges, the gain on the sale of facilities and net loss from the litigation settlement, as well as the cumulative translation adjustment related to the closure of one of our foreign subsidiaries. Before I go into a review of our fiscal Q3 financial results, I will turn the call over to our newly appointed President and CEO, Chuck Berger. Chuck?

Thank you, John, and welcome, everyone to our third quarter fiscal conference call earnings release. As you know, this is day 3 for me at Extreme Networks. Therefore, I will let John Kurtzweil drive this call for review of the financial results. And I have also asked Dave Ginsburg, Senior VP, Product Line Management and Chief Marketing Officer, to cover the market and business discussions. I do want to share with you what attracted me to Extreme and where my key areas of focus have been since day 1, short 2 days ago. Extreme has always been known for its leading edge, competitive technology at the high end of the market. As the upcoming business discussion reveals, our product direction has been rationalized and has gained increased traction in the marketplace in the form of customer acceptance and analyst plaudits. We have a significant global installed base of existing customers. That said, the disappointing operating results of the past few quarters clearly point to a need for better execution across the board. I am confident that given our technology strength, our strong product portfolio, our incredibly strong balance sheet and our talented team of people, we can deliver better execution and therefore, better results in the near term. Frankly, I see this for the entire company and for our shareholders as a highly unique opportunity where there are many positive leverage points. I want to reiterate the commitment of our board, the management team and the entire staff to focus on driving meaningful, positive revenue growth and towards increasing margins. I can think of no better way than that to drive increased shareholder value. With $189 million in cash and no debt, we certainly have the financial strength to back our efforts. I will now turn the call back over to John.

Thank you, Chuck. I will now provide a review of our financial -- of our fiscal Q3 financials, our business results and our financial targets for our fiscal Q4. We will then open the call for Q&A. Revenues for Q3 in fiscal 2013 were $68.2 million, which fell short of our guidance of $70 million to $75 million. Sequentially, revenues were down from Q2 by $7.3 million or 9.7% and down $15.1 million or 6.5% year-over-year. Orders came late in the quarter and the mix was different than forecasted, which led to inventory shortages against the orders actually placed. The book-to-bill ratio was approximately 1.1 for the quarter, and we entered our fourth fiscal quarter with a healthy backlog. Product revenues were $54.1 million, a decrease of $6.2 million sequentially. Service revenues were $14.1 million, a decrease of $1.1 million sequentially. Americas revenue were $28 million and down $5.5 million or 16.3% from Q2 FY '13. South America was a primary contributor to the decline of revenues as expected due to this time of year being the time for their summer vacations. Further, we typically enjoy -- experience lumpy revenues from this region based on the deals and the deal size that we are pursuing. EMEA revenues were $28.5 million and were down slightly $0.2 million or 1% from Q2 FY '13. Southern Europe, including the Middle East, were the weakest regions, with the strongest results in the Eastern block. Asia Pacific revenues were $11.7 million, down $1.6 million or 12.4% sequentially from Q2 FY '13. China and Australia and New Zealand were the weakest regions, with solid performance coming out of Korea. This is a typical down quarter for this region with Chinese New Year and summer vacation season in the Southern Hemisphere countries like Australia and New Zealand. Overall, GAAP and non-GAAP gross margins were 55.6% and 55.9%, respectively, and slightly above the high end of our target range of 54% to 55%. They increased sequentially from both the first and second fiscal quarters of this year due to better inventory management, cost controls, as well as a richer product mix this past quarter. GAAP operating expenses of $39.8 million decreased by $4.7 million from Q2 and were above our target range primarily due to the settlement -- due to the settlement and legal fees associated with the Enterasys's claim of $2.6 million, which was not forecasted, and $0.4 million greater restructuring charges than targeted. Non-GAAP operating expenses of $34.5 million were down $3.8 million from Q2 and slightly less than the targets of being down $4 million to $4.5 million, primarily in sales and marketing related to transitions delays from the restructuring taken in the second quarter and G&A to support ongoing patent litigation. Included in GAAP operating expenses are items that we do not included in our non-GAAP expenses. They were $1.1 million of a restructuring charge, $1.8 million of stock-based compensation and legal expenses, plus litigation settlement costs of $2.6 million. Non-GAAP R&D was $9.1 million, non-GAAP sales and marketing was $19.9 million, and non-GAAP G&A was $5.5 million. Third quarter GAAP operating loss was $1.9 million and non-GAAP operating income was $3.6 million or 5.3% of revenue. Non-GAAP operating income increased by $1 million sequentially to $3.6 million. Other income for the quarter was $0.1 million and taxes were flat for the quarter at $0.4 million, and were primarily related to our foreign income. GAAP net loss for Q3 was $2.2 million or a loss of $0.02 per diluted share versus a net loss of $4.2 million or $0.04 per diluted share in the second quarter of fiscal 2013. Non-GAAP net income for the quarter was $3.3 million or $0.04 per diluted share versus net income of $2.8 million or $0.03 per diluted share in the second quarter of 2013. The non-GAAP results met the low end of our target range of $0.04 to $0.08 per diluted share. Turning to the balance sheet. Cash and investments for the quarter ended at $189.1 million as compared to $196.2 million at the end of last quarter. Previously, we announced a $75 million share repurchase plan, which covers the next 3 years and will be reviewed at least annually by the Board of Directors. During the quarter, we repurchased 1.2 million shares for $4.2 million. Since program authorization, we have repurchased 3 million shares for $11 million. Please note that one of the primary goals of the share repurchase plan is targeted to maintain the value of our deferred tax assets. Because of this, it is currently expected that purchases will occur unevenly over the 3-year period buyback -- or the 3-year buyback period approved by the Board of Directors. The repurchase program may be suspended or discontinued at any time. Any repurchased shares will be canceled and will not be available for corporate -- for future corporate purposes. Other major cash expenditures for the quarter were related to the settlement of the Enterasys -- with Enterasys mentioned earlier of $2.6 million and the payout of $4.3 million for the previously announced restructuring. Without these 2 items, cash would have been up slightly, which would have fully funded the share repurchase for the quarter. Accounts receivable increased by $1 million sequentially in Q3, with DSO increasing by 6 days to 58. The increase in DSO was primarily due to the volume of orders booked late in the quarter and a large distributor not taking advantage of early payment discounts. Inventory decreased by $2.2 million to $15.7 million, with days of inventory increasing by 1 day to 56. In January, we announced plans to realign our cost structure, reaffirming our focus on driving company performance. As we discussed in our last call, we have begun restructuring the company by consolidating several functional groups into our facility in Raleigh, North Carolina. We expect the consolidation to lower costs, and over time increase overall productivity. During Q3, we began to execute on these specific transformation activities. And we still expect to complete the majority of these actions within this fiscal year. While these operational changes position us well in terms of our overall cost structure, I want to estimate -- I want to emphasize our focus on driving revenue growth. Although still a relatively small percentage of our overall business over the past 12 months, we have experienced significant growth in the deployment of our next-generation 10G and 40G technologies. At this time, I will turn the call over to David Ginsburg, our Chief Marketing Officer, for a brief commentary on customers and market traction. David?

Thank you, John. During the quarter, we reaffirmed our position as the technology leader providing switching infrastructure for those customers requiring the combination of performance and highly competitive total cost of ownership. We believe we have managed our restructuring efforts to allow us to continue to maintain our technology lead. Two public test events helped validate our engineering execution. First, EANTC in Europe sponsors yearly interoperability testing targeted at service providers. They validated our industry-leading timing and synchronization solutions for mobile backhaul and tested SDN-delivered OpenFlow. It was the first time vendor implementations were held to a set test plan, and we proved our ability to operate within a multi-vendor environment. Second, in the U.S., we once again participated in Lippis Report testing. As you may remember, in the fall of 2011, we announced that our BlackDiamond X8 data center switch had demonstrated best-in-class throughput, latency and per-port power consumption. At the time, we also tested our Summit X670, 10 gig, 40 gig, top-of-rack switch for the same characteristics. In January of this year, Lippis conducted the first ever active data center fabric test. In the presence of strong competition, the combination of our BDX and our X670 demonstrated best-in-class fabric latency, predictability and resiliency. Basically, we have the best independently tested open fabric offerings in the industry. Our overall data center strategy was also recognized by Forrester by designating Extreme Networks as a strong performer in their January 2013 Forrester Wave. The placement is based on a combination of products, customer traction, vision and partnerships. We share this distinction with a number of vendors who are substantially larger than us. After the end of the quarter, we achieved VSPEX certification that validates the role of our switch as part of a partner-led block architecture. This, in combination with our channel, will help drive enterprise volume. We also announced our intent to support the OpenFlow-based switch light client, heralding a new class of SDN-optimized edge switches to complement our existing portfolio. This existing portfolio, including our stackable and our chassis-based switches, now supports both OpenFlow and OpenStack via a generally available ExtremeXOS release. Turning to specific market segments. The BDX, once again, experienced strong traction across a mix of market verticals. Newly announced BDX wins in the United States included data holdings, a major data center operator in the Midwest; and NCSA Blue Waters, a new petascale computing facility. In the U.K., Imagination is using our BDX to support their massive global growth and to act as the main site for their deployment computing work. High bandwidth to 10 gig servers and guaranteed uptime were 2 key requirements. We shipped additional systems to Moscow-IX, the premier Internet exchange in Russia and a major data center operator in Finland, also began deployment. During the quarter, we also shipped a quantity of systems to a major network equipment partner of ours. To date, we have deployed over 100 chassis across over 50 customers with quality and performance as intended. In the campus space, recent wins included King Fahd University in Saudi Arabia, City of Champaign in the United States, and Intermarché in France. In Russia, the TsAGI Central Aerohydrodynamic Institute, one of the largest scientific research institutes in the world, is deploying our hardware as part of an overall infrastructure upgrade. The Gdynskie Centrum Innowacji in Poland is an example of the BDX deployed as part of a new campus backbone, where the platform offers a future-proof path for expected bandwidth growth. We are beginning to see other deployments of the BDX in this type of scenario. Samsung continues to be a major customer. And on the back of the recently announced R5 research building outside of Seoul, we were also awarded the new headquarters for Samsung SDS in Seoul. Samsung SDS is Korea's largest SI company, and this is the first time this organization moved away from one of our major competitors in 20 years. Our first win within Samsung Global business was in China, as part of their Chosun LCD plant. Closely related to the campus are 2 of our more recent initiatives for market differentiation. Our strategy is to focus on areas where we can demonstrate technical leadership. For example, the data center and cloud. In the extended campus, we leverage our switching portfolio and ExtremeXOS as the network middleware to add value to physical security over IP deployments. Here, we provide the converged Ethernet infrastructure for IP security cameras, HVAC and access control systems. One of our largest wins to date in this space is a major subway project in India. We've also released a novel approach to IP camera control with one of our partners, Axis, that leverages the extensibility of our operating system. Audio/Video Bridging or AVB is another area where we've taken a leadership role. We began to develop protocols for this space over 2 years ago, leveraging our deep expertise in network timing. In February, we became the first enterprise-class Ethernet switch to support AVB in a generally available release. We are already beginning to deploy our first AVB networks and know this is a nascent market today. We expect it to grow substantially in the coming years. At the recent NAV conference, our product was displayed prominently in our partner's booths. Some of our technology partners in the AVB space include Axon, Barco, Riedel, Biamp, Avid and Harman. With our partners, we are developing an understanding of this market, as well as the required design expertise. As an example, our Summit X670 switch is a key component of Barco's reference architecture for their Nexxis Operating Room over IP products that have already gained wide acceptance. This solution will soon leverage AVB. We are beginning to generate our first revenue via this strategic partnership. Tying together our wireless LAN products, our unified communications technology partnerships, physical security and AVB into a future-proof Ethernet infrastructure, we've announced the Open Fabric Edge. This extends our Open Fabric messaging based on standards and interoperability now into the campus, and the architecture has been very well received by customers, partners and analysts. We continue to drive repeat revenue across many of our major customers spanning industrial, finance, education, Internet exchange providers, high-performance computing and network equipment providers as well. And at this time, I'll turn the call back over to John to discuss our targets for our fiscal fourth quarter of 2013. John?

Thank you, Dave. For the fourth quarter of fiscal 2013 ending June 30, 2013, we are targeting revenue in the range of $73 million to $77 million, with GAAP and non-GAAP gross margins targeted to be between 54% and 55%. For both GAAP and non-GAAP, R&D expenses are targeted to be sequentially flat. Sales and marketing expenses are targeted to increase by $0.5 million to $1 million depending upon the revenue levels. G&A expenses, on a GAAP basis, are targeted to increase by approximately $1.1 million, and on a non-GAAP basis, they are targeted to be sequentially flat. Restructuring charges are targeted to be $0.5 million. Interest income and other expense are targeted to be approximately $0.2 million, and tax expense targeted to be approximately $0.5 million. GAAP net income is targeted at $1 million to $4 million or $0.01 to $0.04 per diluted share. Non-GAAP net income is targeted in a range of $4 million to $7 million or $0.04 to $0.08 per diluted share. The GAAP and non-GAAP net income targets are based on an estimated 92.5 million diluted weighted average shares. Targeted non-GAAP earnings exclude expenses related to stock-based compensation expense of approximately $1.6 million, restructuring charges of approximately $0.5 million and $1.1 million of one-time CEO transition expenses. For those of you who are building financial models on the company, we are targeting a quarterly financial model with a goal of achieving non-GAAP gross margin of 56% plus or minus, and for non-GAAP operating income of 10%, plus or minus, at a revenue level just below the $80 million mark per quarter. To help achieve this goal, the company remains focused on growing its revenue with higher performing, lower-cost products, as well as further realigning its cost structure around the set of products. We will now open the call for questions. Sam, can you start the polling, please?

[Operator Instructions] Our first question comes from Christian Schwab of Craig-Hallum Capital.

Chuck, welcome to Extreme Networks. In your vast few days at the company, just wondering what some of these many positive leverage points that you think are unique to Extreme are, if you could highlight some of those for us?

Christian, I look forward to meeting you in person and I'd be happy to do that again, tempered with 2 full days on the job. As I said in my opening remarks, I think we have a number of leverage points. The first and foremost, is our core technology backed by 180 patents and patents pending that if you listen carefully to Dave's remarks, are pulling us into a number of leading edge application areas, which are just starting to produce revenue and I think creates an enormous leverage point for us as we go into the future. The technology and the products backed by a strong team of people, but a team of people, frankly, who need help in executing better and working better across functional lines as the entire company and as a team. We certainly have a strong group of customers and are getting better and better at getting repeat business from those customers, an area I think that where we have a lot of leverage that we can improve on. Our focus on -- is our ongoing service revenues from those customers. I've met a lot of good people, I've got a lot of people to go to meet, but we have a strong people who have committed themselves to Extreme, in many cases over a long career, which is clearly a leverage point. And finally, we have a strong balance sheet with nearly $200 million in cash and no debt. We have the resources to not only look inward to expand our technology base and improve our execution, but longer term, if we see appropriate. Other technologies that we might like to acquire, we have the financial strength to do that. And I'm very excited about the collection of those in terms of what, I think, we can produce going forward in terms of a stronger company and increased shareholder value.

Great. John, are you in a position yet where you can break out what your quarterly revenue was this quarter in the 10 and 40-gig products?

Well, based on our product revenue, it's pretty similar to last quarter but down just a little bit. And what we saw were that some of the orders that I mentioned earlier that came in later in the quarter were -- we were inventory constrained due to mix was related to those products. So it was down just a tad, and the backlog looks like it should be up next quarter.

And when you guys look at the large data center, cloud revenue opportunities, did you close any deals in the $500,000 plus category? And in your book-to-bill, which is very healthy at 1.1, are there some larger $500,000 to $2 million deals in that, that need to be closed in June?

Yes, there's -- we always have deals that are in that range. Last quarter, we had a couple of deals that closed that were over $1 million, that are in the backlog, that we'll be delivering on this quarter. So we expect to be able to continue. Part of where that comes from is as we get more and more into the data center, we're able to provide the data center products, as well as some of the edge products as well. And that's helping the breadth of the product portfolios helping the revenue size.

Yes, and given your technology leadership and the increased adoption, particularly of 10 gig and accelerating potentially in 40, how big of a business do you believe that could be, David, in 2 to 3 years?

Thank you for the question. The only thing I can reference are some of the third-party analysts, which would include Dell'Oro. Try to characterize the size of the 10, 40 and 100, the new 100-gigabit per second market where we have investments as well. I would say that over the course of time, our overall revenue should close -- should reach a closer approximation of what Dell'Oro is calling. And you've heard in the past, our statement that anywhere from 40% to 60% of the revenue in the outyears should come from higher bandwidth products. I agree with that prediction.

Great, great. And then my last question, if I may, is how many existing customers do you have?

At this time, we have over 6,000 customers in terms of -- that we serve direct through our channel partners or through our distribution channel.

[Operator Instructions] Our next question comes from Rohit Chopra of Wedbush Securities.

This is Sanjit Singh sitting for Rohit. Chuck, welcome to the team. Just a couple of questions on the quarter. If you just characterize where -- were there any particular verticals on that sit out as being points of weakness? Do you have any federal exposure? It seemed like the overall IT spending environment was weak this quarter, so I'm trying to separate out what was more macro driven versus maybe more execution specific-type weakness.

Dave, why don't you take that from the market standpoint?

Sure. So if we look at where we target the company and we've sort of mentioned this in the past. We have good traction, mid-market enterprise, education, not federal government, but we're actually pretty strong in some of the overseas government deployments. Those markets have held up for us. I would say that the data center market also was strong with the exception John mentioned, that some of the orders were backloaded and turned into the one to one, 1.1 book-to-bill ratio. But you're correct in that there's overall cautiousness in spending. And I think that was the one thing that was an overall dampener across all of the verticals, not necessarily made more visible in any specific vertical for Extreme Networks.

I appreciate the answer. As it relates to looking at next quarter's guidance, John, what are you assuming there in terms of close rates? How cautious are you in terms of your assumptions regarding the pipeline? Just want to get a sense of how you're thinking about guidance given kind of the weaker macro backdrop?

In terms of weaker macro, the background on the environment into account when we look at this, what we saw was that we saw a higher book-to-bill ratio for this quarter, some business that was going to be carryover into next quarter. And that's how we came up with it. I think we're definitely cognizant that the environment is weak, but we are seeing a good -- and when we look at it, we're looking at a good pipeline of orders and products that we should be able to close on. So we're pretty comfortable within that range on revenue.

I would comment that I spent the better part of the day looking at our backlog, our pipeline against the forecast for the fourth quarter, and I'm used to typically at least 3x, if not larger, opportunities that could close in order to get to a number, and we're well within that range.

That's great insight. I appreciate that. Last couple of questions here. Regarding the inventory shortages, what was -- was there any type of root causes behind that, or just a surprise in terms of what the customer requests were in terms of the products? And then, John, on the stock-based comp, is there any way you can break that out between the OpEx line items for, let's say, cost of product, cost of service and R&D, SG&A and sales and marketing?

Yes, I'll be able to break those out for you. And when we look at the inventory where the issue was, it came really with the -- some of the larger orders we thought we're going to get next in the fourth quarter, came in earlier than forecasted, which put a damper on our ability to shift. As you saw inventory was down, we filled what we could. And from that, we have a list of shortages that we're working, and we think we should have all the shortages alleviated by the middle of May. And then for the stock-based compensation, when I look at the split, just one second here, let me get to that.

I would add to the inventory business, we've worked very hard or the team has worked very hard prior to my arrival to managing our total asset base as closely as possible. When you do that, of course, you run the risk of last-minute orders not being fulfillable against the lower inventory levels, and that's also maybe something that we'll look at going forward as to where the healthy balance is there.

And then the split on the stock-based comp, there was about $200,000, and our cost of goods sold and R&D was about $300,000, about $0.8 million in sales and marketing, and about $0.6 million in G&A.

Thank you. And at this time, I'm not showing any further questions. I'd like to turn the call back to Mr. Chuck Berger, CEO, for any further remarks.

Thanks, everyone, for joining us. I apologize that I'm not fully up to speed on the business yet after only a couple of days, but I assure you by the time that we talk again in this forum, I will have a much more complete view of the business and grip on questions that you may need answers to or want answers to, as well as where the key leverage points are in the business versus my initial expectations, and how we're actually performing against them in the fourth quarter. I cannot tell you how excited I am about this opportunity. As you probably read, I recently completed a successful sale of my prior company, ParAccel, which was just exploded into the market for big data in the high-end MPP database space. And although I probably would have been wiser to take a couple of weeks off, I just was chomping at the bit and couldn't wait to get here. So I'd literally announced that sale Thursday morning and was here at Extreme Thursday afternoon. I just think there are so many things that we can do even just a little bit better, and many we can do a lot better that will have dramatic leverage and dramatic impact. So I look forward to future calls. And with that, we'll end the call.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.